How DB schemes lost their sheen

The outgoing chairman of the National Association of Pension Funds, one of the leading pension industry bodies in the UK, recently suggested that no final salary or defined benefit (DB) schemes will still be open in the UK within five years.

Yet only a few years ago DB schemes represented the primary form of pension provision for UK companies, and it was estimated that the amount of money in UK funded DB schemes was greater than the amount in similar schemes in the rest of Europe combined.

So what happened to cause this shift? Some would say that it hails back to a totally unrelated incident almost 15 years ago.

For many people, the root cause of the current situation can be pinpointed to an event which took place on 5 November 1991, when Robert Maxwell, chairman of Mirror Group Newspapers, was found dead overboard his yacht. He left in his wake one of the biggest pension scandals that the UK had ever seen.

The implications of this incident have been farreaching, rippling throughout the entire UK pensions industry in the form of successive waves of legislation. In the space of a few short years, the UK pensions environment was irrevocably transformed from one where companies called the shots in the 1990s, to become the more regulated, onerous environment that employers currently operate in.

Then in the 1990s:

❒ Scheme design was the choice of the employer, and could be designed to meet recruitment and retention needs.

❒ Schemes could be funded using an approach determined by the company, with no minimum level of funding.

❒ Pension schemes were referred to in notes to the accounts, but not on the main balance sheet, meaning that the impact was less visible to shareholders.

❒ No Pensions Regulator existed to oversee and police how a company ran its scheme.

❒ A company could walk away from the scheme at any time, regardless of whether it had enough money.

Now by the present day (post Pensions Act 2004):

❒ Anyone providing a DB pension scheme can only do so if the scheme meets certain design criteria, including providing spouses pensions, annual pension increases and, in many cases, a minimum accrual rate.

❒ It is a legal requirement for schemes to be funded on ‘prudent’ assumptions, meaning that the company is obliged to set aside more money for the pension scheme.

❒ Once that money is paid into the pension scheme, it cannot be taken out except under very strict circumstances.

❒ The pension scheme must be valued on a statutory basis and any shortfall disclosed on the company balance sheet, making any deficit far more visible and subject to short termism.

❒ The Pensions Regulator can become involved at any stage and demand additional funding for the scheme. The Regulator can also influence corporate transactions if he deems they have the potential to threaten the pension scheme.

❒ If a company wants to exit from a scheme, it is liable for the full cost of buying out benefits in the scheme, even if this means it would leave the company insolvent.

❒ In the meantime, companies must pay levies into an insurance scheme, to cover the risk of insolvency.

While this set-up is great for members, it is extremely onerous for employers. And it is indeed ironic that an individual whose companies left many of their employees without their full pensions was the cause, albeit unintentionally, of safeguarding pensioner rights going forward and imposing additional pension costs on business.

Looking at the original pensions scheme structure, most points outlined now seem archaic and irresponsible. And very few would argue that the governance and regulation of schemes should revert back to such a position. However, with the implementation of the Pensions Act (2004), it is understandable how the major changes that have taken place have left companies wondering if their decision to provide pension benefits for employees was a wise one in the long term.

Shortfalls

Most pension schemes in the UK have a shortfall at the present time, in other words, there are not sufficient assets in the scheme to meet the liabilities. Recent Aon calculations estimate that the total shortfall for the top 200 pension schemes in the UK, measured using an accounting approach, is around £40bn (e .

The reasons for the shortfalls come down to four issues:

❒ First, the increasing demand being placed on pension schemes through government-driven improvements to benefits. These have increased pension costs and made pensions gradually less affordable.

❒ Second, the rigour with which past pension promises are being enforced, with companies required to set aside greater reserves than expected.

❒ The third reason is the poor performance of the financial markets. Equity prices are still not performing as well as they were six years ago, while bond yields (which influence the price of pensions) have been steadily falling.

❒ The final factor is the length of time which pensions must be paid out. This has been increasing steadily, due to improved living standards and advances in healthcare. Nowadays, life expectancy is steadily increasing by around two years for every 10 years that passes.

The reaction from companies has been to take the necessary measures to exit final salary pension schemes in the long term. This is happening in three stages:

❒ The first phase has been closing to new recruits, and according to a recent Aon survey, which polled 115 UK companies operating DB schemes, found that over 70% of schemes are no longer accepting new members.

❒ The second phase is likely to be closure to existing members, and Aon’s figures suggest that 10% of schemes are now closed to accrual as well.

❒ The third and final stage will be the wind-up of those schemes, removing them from the books of companies. Despite recent developments in this market, this final stage is likely to take many years - probably decades.

According to Aon’s survey, the closure of schemes is likely to accelerate in the next three years, with the forecast position for 2009 looking as in the table:

The research also found that companies who find it hard to close to accrual will embark on alternative measures to keep costs under control. For instance:

❒ Seventy two per cent of UK companies surveyed are considering increasing member contributions in the next three years, with 36% considering this in the following 12 months.

❒ Twenty per cent of companies operating DB schemes are considering increasing the normal retirement age in the next 12 months, with 43% considering this in the next three years.

❒ Twenty six per cent of survey respondents are considering reducing the rate of benefit accrual in the next 12 months, increasing to 48% within three years.

Interestingly, these changes represent an ad-hoc form of risk-sharing, whereby the company makes changes to scheme design in response to changing conditions.

Setting up DB schemes with more formalised risk-sharing is one way that DB pension provision might remain affordable and survive. Without such a change, the decline of such schemes is all but certain.